I believe stockmarkets are far from efficient. Correctly valuing a business is an extremely difficult problem that requires investors to predict the future and is lacking in clear sensible benchmarks. It is unsurprising that investors systematically and collectively get this valuation wrong in various ways. Markets are also affected by emotional swings, information problems and liquidity issues. The result is that many shares are mispriced and often dramatically so.
There are many strategies to exploit these systematic mispricings and ‘beat the market.’ However, they are not straightforward to define and implement. This is largely because it is difficult to generate sufficient evidence to really know whether a strategy will outperform in the long term – ‘is my strategy doing well or am I just being lucky?’ On one hand this makes things very difficult, but on the other hand it makes it easier for bad strategies and mispricings to persist, leaving more to play for.
As a result, I believe it is important to have clear logic and evidence behind a strategy so that you can have faith in it to weather the periods of underperformance that may arise. A strategy also needs to acknowledge the inevitability of mistakes and have a clear plan for dealing with them.
My strategy is focused primarily on exploiting two particular factors in combination: a) the tendency for high quality defensive businesses to outperform over time and b) the tendency of shares with momentum to continue to do well.
So how have I arrived at this? My main source of inspiration is all the empirical evidence supporting ‘factor investing’. This is the idea that shares with certain qualities (e.g. value, quality, momentum, small caps) are statistically more likely to outperform the market over the long term. Over the past few years I have followed the outperformance of the ‘Stockranks’ developed on Stockopedia with great interest. My other inspiration is Warren Buffett, who demonstrated that you could get phenominal returns from investing in high quality defensive shares over the long term. In the UK I have drawn from the approaches of Terry Smith and Nick Train, who follow in this tradition.
There is empirical evidence that factors work better in combination with one another. Intuitively this makes sense – for example it is difficult to think about the ‘value’ of a share in isolation from its ‘quality’ – the two are part of a bigger whole. How best to combine factors is a challenge of limitless complexity. Stockopedia’s Stockranks suggest that a simple weighted index can work very well but I see this as a starting point rather than the only or best approach.
The backbone of my approach is to first consider the long term quality of shares independently of their prices and to screen out all potential investments unless they are very high quality. I then decide which of these to invest in at a given time on the basis of their current pricing, taking account of momentum and to a lesser extent valuation. To me this structure of choosing investments makes better intuitive sense than applying all factors simultaneously. Quality is a more long term concept. While momentum and value are functions of the share price, quality is not.
‘Quality’ is a broad concept and hard to define or measure. In principle, it is determined by how much profit a business is likely to make over its whole lifetime. Luckily to do well you don’t need to predict this in an absolute sense, but can more simply identify which businesses are higher quality than others. This is possible with the easier question ‘does the business possess characteristics which make it more likely than other businesses to be able to compound (profitably reinvest) its profits over the long term to a greater extent?’
In practice quality factors are metrics that can range from measures of a business’s balance sheet strength, its historic ability to generate and profitably reinvest cash and the quality of its management. Some of these factors are predictive of future profitability. However, they are often not of much value in isolation but need to be looked at collectively within a sensible framework. Qualitative assessment is an important supplement to looking at metrics, particularly as assessing quality is basically attempting to predict the future. To do this you need to have a view about things like whether a company has a competitive advantage that will endure and whether it is in a defensive, growing market.
Why the highest quality is undervalued
To assess the valuation of a business properly you would need to account for quality by incorporating the compounding of future growth into the valuation. Traditional ‘value factors’ don’t do this. These measures, like the Price Earnings ratio, are pretty useless in isolation as they do not attempt to properly assess a share’s actual worth. A share’s worth is determined by what will happen to profits in the future, while these value measures look to the past. If you are buying a decent business that you expect to grow, i.e. the kind of business you should be buying, this is not so useful. Value metrics will treat a business with low costs and a highly valued product protected by IP the same as a business in a highly competitive market that is having to reinvest all of its profits just to stay afloat.
The indiscriminate application of these sorts of valuation metrics across all sorts of businesses results in a huge pitfall or opportunity – it is very easy to underestimate the implications of future compound growth on present valuation. While investors often have an idea that one business appears a better long term prospect than another, they tend to underestimate the implications for its valuation. As a result, the market tends to systematically undervalue high quality businesses.
Another reason that quality is undervalued is that it is fundamentally difficult to assess, particularly as it incorporates a lot of qualitative as well as quantitative factors that need to be thought about collectively. People often tend to focus unduly on what they can measure.
In most cases the highest quality businesses will trade on apparently higher PE ratios relative to average businesses, but will still be relatively cheaper when you more carefully consider their likely profitability over the long term. This is because the highest quality businesses possess characteristics which will allow them to sustainably earn high profits and grow without needing to invest huge amounts, while average businesses will only at best be able to do so for shorter periods before competition is attracted or the business cycle turns. In the very long term, returns in the stock market are very unevenly distributed across businesses, with a small minority of high quality businesses taking the lion’s share. Quality investing is essentially about identifying these businesses.
This is part of the rationale for one of the key features of my approach – that I focus much more closely on identifying high quality than on thinking about valuation. I do this not because I think valuation is unimportant but because I believe the market is biased the other way.
Momentum fits well
The other complementary aspect of my strategy is to exploit share price momentum. In terms of factor investing I think momentum is the closest thing there is to a free lunch. Momentum arises for a very large number of compelling reasons to do with the underlying performance and characteristics of the business, investor behavioural biases, information issues and liquidity. Surprisingly, it can often be a good indicator that a share is undervalued. See my post on momentum to see why.
Momentum is easy to observe and to implement into a strategy so is a powerful tool in practice. Exploiting momentum involves buying shares that are rising in price and especially just after issuing positive news, or selling shares that are falling in price and especially just after issuing negative news. Run winners and sell losers! I think you’re missing a trick if you are a private investor who doesn’t incorporate momentum into your investing strategy in some form – the ability to exploit momentum well is one of the big advantages small investors have over larger institutions who suffer from holding large illiquid positions.
Exploiting momentum also is complementary to focussing on very high quality shares as these should tend to exhibit more consistently rising prices over the longer term. Momentum, particularly over the longer term, can therefore be a useful indicator of quality in conjunction with other factors.
Another benefit of exploiting momentum is that it provides the discipline to deal with mistakes effectively. Identifying quality is hard. The only thing certain about the future is that I can’t predict it with certainty, so I want to have a strategy that is going to miminise losses from mistakes rather than lead me to anxiety and poor decision making. I don’t really want to experience the ‘value investor’s headache’ – ‘is the share price falling a good thing that means I should buy more or the sign of a terrible mistake?’